| FRBSF Economic Letter
2005-09; May 20, 2005
Can Monetary Policy Influence Long-term Interest Rates?
There is a well-worn story that
illustrates how economists view financial markets (and,
perhaps, the rest of the world). An economist and a non-economist
are walking down the street. The non-economist spots
a $20 bill on the sidewalk and starts to reach for it. "Don't
bother," says the economist. "If it were real,
somebody would have picked it up already."
A version
of this story explains, in part, what moves long-term
interest rates. Long-term nominal interest
rates should be an average of current and expected
nominal short-term rates. For example, the return on
a six-month
Treasury bill (T-bill) should be comparable to the
return on a three-month T-bill that gets rolled over
for an
additional three months. If the returns on these two
six-month investments with similar risk differed significantly,
there would be an arbitrage opportunity consisting
of selling short one investment and buying long into
the
other for a positive profit at zero net cost. And,
to an economist, that's just as unlikely a possibility
as
that someone had walked past a $20 bill lying on the
sidewalk.
This "no arbitrage" argument plays
a critical role in the way monetary policy decisions
affect the
economy. The Federal Reserve makes decisions about
a very short-term rate—the federal funds rate,
which is
an overnight rate. And because, in theory, there are
no arbitrage opportunities, the market's expectations
about future changes in the federal funds rate will
influence market rates of much longer maturities today
and eventually
aggregate spending (especially investment)—the
ultimate goal for controlling inflation.
The problem
is that researchers who examine the relationship
between short-term rates and long-term rates find little
empirical evidence to support the "no arbitrage" argument.
As a result, it would seem that the Federal Reserve
does not have any influence on long-term rates.
This
Economic Letter argues that the Fed exercises
significant influence on long-term rates. The key
to reconciling
this position with the empirical evidence resides
in the gradual pattern of policy interventions characteristic
of the Federal Open Market Committee (FOMC). This
pattern,
a likely reflection of the Fed's response to changes
in economic activity in the long run (see Rudebusch
2002), is essential to understanding fluctuations
in long-term
rates. Monetary policy gradualism
and the 3.75% rule of thumb
 Figure 1 displays the federal funds rate target from
March 1984 to March 2005 and shows that the Fed usually
undertakes a change in the policy stance in a measured
and gradual way: the Fed moves in small incremental steps
in the same direction over a long period of time. In
fact, a crude average over this period suggests that
once a new policy direction is taken, the Fed will increase
(or lower) this target by 3.75% over the span of two
years at a rate of 0.165% per month (approximately 25
basis points per FOMC meeting over 15 consecutive meetings).
Suppose
we take the 3.75% rule of thumb and apply it to the
latest round of Fed increases, which began at
the June 30, 2004, meeting, when the FOMC raised
the federal funds rate from 1% to 1.25%—the first increase
since May 16, 2000. It would mean that the FOMC would
continue to increase the funds rate up to 4.75% by
June 2006 and keep this rate fixed at that level thereafter.
What would this observation imply for bond yields
in
a "no arbitrage" world?
 Figure
2 provides the answer to this question. The line labeled "predicted" is
constructed by taking the average funds target rate
over the maturity of the
bond displayed, assuming a 0.165% increase in the target
per month up to 4.75%, after which it is kept constant.
The proximity of the predicted and actual yield curves
is quite remarkable, considering that this simple prediction
does not incorporate either any risk premia or any
predictions about the future values of macroeconomic
fundamentals
and that the prediction is not based on sophisticated
asset pricing models. As the figure shows, absent any
new developments in the economy, the yield curve would
progressively flatten until rates at all maturities
reach the 4.75% mark, somewhere around June 2006.
Therefore,
Figure 2 suggests that the Fed does influence long-term
rates significantly, and it does so by setting
a target for the overnight rate. Furthermore, the
absence of significant premiums on longer-term Treasuries
is
a public vote of confidence on the Fed's stewardship
of its control of inflation in the long run.
As we will
see shortly, FOMC meetings held at these juncture
points (when a direction of policy is first
reversed)
very likely provide markets with more information
than other meetings do, as Figure 2 seems to suggest.
This
is because it is difficult to make long-range predictions
on economic activity with which to predict the future
path of the federal funds rate. Markets therefore
find these policy reversals useful in pricing bonds.
Once
the Fed has initiated a new round of adjustments,
intervening FOMC decisions are probably well anticipated
by markets
and already discounted into bond prices. Changes in the fed funds
rate: when are they informative and when are they "old
news"?
In a recent paper, Demiralp and Jordà (2004)
examine whether changes in the federal funds rate target
provide different kinds of information at different times.
In particular, they distinguish four types of policy
action: (1) changes done at regularly scheduled FOMC
meetings which are in the same direction as previous
changes; (2) changes done outside a regularly scheduled
FOMC meeting (which has happened four times since the
Fed began making public the outcome of FOMC meetings
in 1994) but in the same direction of previous changes;
(3) changes that signal a reversal with respect to the
prevailing policy stance up to that point (such as the
June 30, 2004, FOMC meeting); and (4) reversals that
are done outside a regularly scheduled FOMC meeting (a
very strong signal indeed and one for which there is
no available precedent, even if one can calculate it
nevertheless).
In order to measure the informational
content of each of these four types of events, it is
also important to
distinguish those events that were well anticipated
by the public (and presumably accordingly priced into
bonds)
from those that surprised markets. One way to measure
market expectations on the federal funds rate target
is to read these expectations off the futures market
for the federal funds rate (which began in 1988 but
for which reliable data is available only since 1989).
This
market consists of futures contracts on the average
federal funds rate prevailing over different maturities,
although
the spot-month rate is all that is needed for the task
at hand. Because of the averaging feature of these
contracts, some adjustments are required to tease out
the nature
of the market's expectations. Kuttner (2001) shows
how this can be done effectively to decompose each change
in the target federal funds rate into a component representing
that portion of the change expected by the public and
that portion that constituted a surprise. Sometimes
markets
will be surprised when the Fed changes interest rates
unexpectedly, but sometimes the surprise will come
when the Fed decides not to change interest rates when
the
market expects a change.
 These elements allow us to
investigate the effect of each of the four types of
policy events described above,
depending on how well these events were communicated
to the markets. In particular, consider the response
of bond rates at different maturities to the surprise
portion of a change in the federal funds rate target.
The results of this exercise are displayed in Figure
3 and are an extension to those reported in table
6 in Demiralp and Jordà (2004) with data up to
March 2005.
The model predicts a one-to-one correspondence
between changes in each term rate analyzed and the
surprise component of a policy action. Figure 3 elucidates
the discrepancy
between what the empirical literature has found
(a
detailed survey of which can be found in Rudebusch's
(1995) article
on how the Fed's targeting patterns can baffle
traditional empirical tests) and the behavior evident
in Figure
2. In particular, policy actions at regularly scheduled
FOMC meetings, within the context of a specific
round of changes, have very little effect (economically
as well as statistically) on term rates except
at
the
short
end of the maturity spectrum (three months to one
year). Even changes in the same direction that
occur outside
an FOMC meeting, which almost by construction are
a surprise to the market, do not carry much more
weight.
In contrast,
the start of a change of direction carries far
more information and is well reflected across the board,
with the strongest
effect felt in the two-to-five year range, which
coincides with the average duration of a new round
of changes.
Naturally, if a new round of changes were initiated
outside an FOMC meeting, the effect would be even
greater. Conclusion
Incorporating the Fed's gradualist pattern of interest
rate decisions into empirical tests and predictions
on the term structure is well worth trying. As Rudebusch
(1995) showed, the measured pace of interest rate changes
over long periods of time can easily trip traditional
econometric models and tests. The results in Demiralp
and Jordà (2004) and the simple example in Figure
2 suggest that the Fed exerts significant influence
on term rates across the maturity spectrum - an observation
that many would have readily accepted but for which
little empirical evidence had been available. A natural
explanation for this dissonance is the difficulty in
producing effective long-range forecasts on the federal
funds rate. This likely explains why the simple (and
very unsophisticated) rule of adding/subtracting 3.75%
over two years at the beginning of a new policy cycle
works so well in describing the yield curve.
Òscar Jordà
Visiting Scholar, FRBSF, and
Associate Professor of Economics, UC Davis
References
Demiralp,
Selva, and Òscar Jordà. 2004. "The
Response of Term Rates to Fed Announcements." Journal
of Money, Credit, and Banking 36(3) part 1, pp.
387-406. Kuttner,
Kenneth N. 2001. "Monetary Policy Surprises
and Interest Rates: Evidence from the Fed Funds Futures
Market." Journal of Monetary Economics 47(3),
pp. 523-544.
Rudebusch, Glenn D. 1995. "Federal
Reserve Interest Rate Targeting, Rational Expectations,
and the Term Structure." Journal
of Monetary Economics 35(2), pp. 245-274.
Rudebusch,
Glenn D. 2002. "Term Structure Evidence
on Interest Rate Smoothing and Monetary Policy Inertia." Journal
of Monetary Economics 49(September), pp. 1161-1187.
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